ARBITRAGE PRICING THEORY

Goal: Description of the theoretical principles

behind derivative security valuation

Model a single-period securities market

with uncertainty
Finitely many \nal states" or outcomes
Finitely many securities traded

Key idea: Absence of arbitrage opportunities

implies relations between securities prices

Methodology applies to most valuation problems in Finance

by suitable generalization of the model

Sources: D. Due, Dynamic asset pricing theory and

notes
2

1. The Arrow-Debreu model

Assumptions:
N traded securities s1  s2  :::  sN
N prices p1  p2  :::  pN
M nal states of the market, in which the securities
provide cash-
ows ( D1 j  D2 j  ::: DN j )
with 1  j  M

p = (p1  p2  :::  pN ) = price vector

D = ( Di j ) = dividend, or cash-
ow matrix

A portfolio is represented by an N -vector

 = ( 1  2  ::: N )

i = number of units of security si held in the portfolio

(long or short). Assumed to be a real number
 Investments & Arbitrage Portfolios

Initially, investor purchases a portfolio ( 1  2  ::: N ) @ price

PN
p = i pi
i=1

Subsequently, one of the M states ocurrs and the investor

claims/pays the cash
ow
PN
D j = i Di j
i=1
if state j ocurred

Denition:  = ( 1  2  ::: N ) is an arbitrage portfolio i

(i)  p < 0 and
(ii) D j  0 8 0  j  M
or
(i)  p < 0
(ii) D j  0 8 0  j  M and
(iii) 9 0  j  M such that   D j > 0
4

No-arbitrage Theorem

Theorem 1: A necessary and sucient condition for the

non-existence of arbitrage portfolios is that there exists a vector
 = ( 1  2  ::: M )  j > 0 8j

such that
p = D
or, equivalently,
M
P
pi = Di j j 8 0  i  N.
j =1

Remarks:
j s are called state-prices
 !
 M
P
Set ^j = j j 0

j =1
0

P
^j s are probabilities : j ^j = 1  ^j > 0
Price of a riskless bond with face value $F = BF =)
M
P
BF = F  j
j =1
 Interpretation of Theorem 1
Assume riskless lending/borrowing exists @ (simply
compounded) interest rate R. Then,
F M
P
BF = 1+R =) j = 1
1+R
j =1

From Theorem 1,
M
P
pi = Di j j
j =1
 !
M
P PM
= j  Di j ^j
j =1 j =1

PM
= 1
1+R  Di j ^j
j =1

= 1
1+R  E^ Di ]  1 < i < N :

No-arbitrage =) there exists probabiliity measure ^ on the

set of market outcomes such that every security satises

Price = 1
1+R  E^ f Cash-
ows g
6

Subjective vs. risk-adjusted probabilities

No-arbitrage theorem assumes nothing about the subjective

probabilities (frequencies) of states 1  ::: M (other than 6= 0)
Assume that investors believe that Prob.f state j ocurrs g = fj

Typically, fj 6= ^j !!

 f 
1
pi E ( Di ) ; pi = expected return for si
 ^ 
1
pi E ( Di ] ; pi = bond return (R)
Historically, securities have dierent expected returns,
which are also dierent from the bond return.

In terms of subjective probabilities (f ), we have

PM  
pi = 1
1+R  Di j ^fjj  fj
j =1
h  i
= 1+R  E
1 f Di f^ 


^j = state-price \de ators"

fj
 State-prices & \elementary claims"

Add to the security space M \elementary securities" sN +1 :::

sN +M such that
8
<1
> if j = k
DN +k j = >
:0 if j 6= k

If there are no arbitrage portfolios with the \enlarged"

securities market
pN +k = price of the kth elem. security
M
P
= DN +k j j
j =1
= k  1  k  M

State price j = price of a hypothetical derivative security

that pays $ 1 in state j and $ 0 otherwise.
Value assigned by the market to $ 1 in state j
8

2. Proof of Theorem 1

A. Existence of state-prices implies no-arbitrage

Suppose that  is an arbitrage portfolio. Then
 D j  0 8j

=)   p =   (D   ) = (   D )    0 (j > 0)
and
  p is stricitly positive if some   D j is positive. #

B. No-arbitrage implies existence of state prices

Will show: if no set of state prices exists, then there is an

arbitrage portfolio
Consider the \distance" function:
P
D(x1  x2 :::xM ) = p ; j xj D j 0 < xi < +1
Claim: this function satises
1. Inf xj > 0 D(x1 x2 :::xM ) = Minxj  0 D(x1  x2 :::xM ) = 0
2. Minimum is attained at some (x1  x2  :::xM ) with
  

xj > 0

8 j (a state price vector)
Proof of 1. Suppose Inf xj > 0 D(x1  x2 :::xM ) = D0 > 0
P 2
=) Inf xj > 0 p ; j xj D j
= D02 > 0

; 
First-order conditions: @D2 =@x2j  0 > 0 i xj = 0 

 P  
;2 p ; j xj D j  Dj  0

Multiplying by xj and adding,



(p ; p )  p = 0 
 
p = Pj xj D j
 

Choose  = ; ( p ; p ) =) 
 D j  0 8j

&  p = ; (p ; p )  p = 
; jp ; p 
j
2
= D02 < 0

Hence  is an arbitrage portfolio. By contradiction, there

P
exist non-negative xj s such that p = j xj D j :
 
10

Proof of 2. Suppose that p = Pj xj D j , but 

no state price vector exists.

=) 9k such that 8
> 0
P
Inf p ;
D k ; j xj D j
> 0:
x1 :::xM pos.
This is due to the convexity of state price vectors: a
convex combination of SPV s is an SPV

Dene p = p ;
D k
Repeating the previous argument, we nd that
P
9 p =

j x~j D j

such that
; ( p ; p )  D j

 0
; ( p ; p )  p =

; jp ; p j2 < 0


Consider the portfolio  = ; ( p ; p ) 



 p = ; ( p
p )  p
; 

= ; ( p ; p )  (p +
D k )


= ; ( p ; p )  p ; ( p ; p ) 
D k
 
 Continued
 p = ; jp ; p j2

; ( p ; p ) 
D k


Case 1: x~k > 0. Then,



( p ; p )  D k = 0


=)  p < 0

Case 2: x~k = 0. Then,



p ; p = ;
D k


=)  p = 0
but also
 D k = ; ( p ; p )  D k > 0


Thus, unless xj > 0


8j there exists an
arbitrage portfolio.
12

3. Example: One-period binomial model

Two securities, a stock and a bond (N = 2), two states (M = 2).

Stock value satises

Risk-neutral probabilities: D  U .
S = 1
1+R  U  S U + D  S D ]

8
>
<  U + D = 1
>
:  U +  D
U D = 1 +R

Solving this 2  2 linear system of equations,

(1+R) ; D
U = U D
;
D = U U (1+DR)
;
;

No-arbitrage condition: D < 1 + R < U

If additional securities are introduced, their market
values are completely determined by the risk-neutral
probabilities

Example: \Contingent claim" has cash-

ows VU and VD
in states U  D. The no-arbitrage value is

V = 1
1+R  U  VU + D  VD ]

Replicating portfolio
Problem: Determine a portfolio of stocks & bonds that has
cash-
ows VU  VD in each state.

Solution:  = # of shares, B = dollars in

money-market account
8
>
<   S U + B (1 + R) = VU
>
:   S D + B (1 + R) = VD

 = SV(UU VDD)
;
;
B = 1
1+R
U VD D VU
;
U D
;
14

Arbitrage strategies

If V < 1
1+R  U  VU + D  VD ]
Buy contingent claim, sell  shares =) riskless prot.

If V > 1
1+R  U  VU + D  VD ]
Sell contingent claim, buy  shares for a riskless prot.
 Market completeness

Denition: An Arrow-Debreu model (market) is said to be

complete i there exists a unique state-price vector .

Proposition 1: Market completeness holds i M = N and

the cash-
ow matrix D is invertible and there is no arbitrage.

Proposition 2: A market is complete i any additional contingent

claim can be replicated using the existing N securities.

Proof: If there are two (dierent) state price vectors 1  2,

D  (1 ; 2 ) = 0 =) D not invertible
D not invertible =) 9y D  y = 0
 =  +
y = state price vector if
is small

As a rule, nancial markets are incomplete.

16

MULTIPERIOD ARBITRAGE PRICING THEORY

Assumptions:

Trading dates: t0 (today) t1  t2  :::  tn  ::: tN

Market can be in one of several states at any particular date.

A state represents information about prices, forecasts, market

\mood" , etc., as well as past information.

Collection of states at time tn : n (nite set)

State of the market at time n : Xn

Prices of securities and dividends paid to holders at

time tn are functions of Xn

S (tn ) = Sn = Sn ( Xn ) represents a security price

D(tn ) = Dn = Dn ( Xn ) \ dividend
or cash-
ow payable to the holder at time tn
 Short-term lending

There exists short-term lending from one date to the

next:
Interest rate at time t0 = R0 (known today)
Interest rate at time tn = Rn = Rn (Xn ) (known at date tn )
18

Risk-neutral probability measures

Suppose that at date tn the market is in state Xn 2 n

Holding security with price Sn for the single period ( tn  tn+1 )

and collecting the dividends + selling it at time tn+1 produces
the cash
ow (not counting cost of purchase)

Sn+1 + Dn+1 = Sn+1 (Xn+1 ) + Dn+1 (Xn+1 )

One period APT =) 9 (Xn+1  Xn ) Xn+1 2 n+1 

P
(Xn+1  Xn ) > 0 & (Xn+1  Xn ) = 1
Xn+1
such that

Sn (Xn ) = 1 +
1
Rn (Xn ) 
P
 Sn+1 (Xn+1 ) + Dn+1 (Xn+1 ) ]   (Xn+1  Xn )
Xn+1

Sn = 1
1+Rn E( Xn ) f Sn+1 + Dn+1 g

 Probabilities on the set of state paths

(Xn+1  Xn ) can be interpreted as a risk-

adjusted probability for the ocurrence of state Xn+1
conditional on Xn

For any n > 0, dene

P0(X0  X1  ::: XN ) =
(X1  X0 )  (X2  X1 )    (XN  XN 1 ) ;

Proposition : P0 (X0    ::: ) = is a probability on

the set of state paths (X1  X2  :::  XN ) , for
Xi 2 i  1  i N

In fact,
P
P0(X0  X1  ::: XN ) = 1
(X1  X2  :::  XN )

P0 (X0  X1  ::: XN ) > 0

20

Multiperiod risk-neutral valuation

Set B0n = 1
1 + R0  1 +1R1    1 + R1 n;1 

Discount factors for lending/borrowing from time t0 to time tn .

Fundamental Theorem of Dynamic Asset Pricing:

(i) If there are no arbitrage opportunities, there exists a probability
measure P0 on the set of state-paths f (X1  X2  :::  XN ) g
such that every traded security satises

Pn
S0 = E f B0i Di +
P 0 B0n Sn g (1  n  N)
i=1

8 expected discounted dividends up to time tn

>
>
>
>
>
<
Today's price = > +
>
> >
>
:
expected discounted market price at time tn
 Martingale Property of prices under P0

(ii) Set
Bmn = B0n = B0m = 1
1 + Rm  1 + R1m+1    1 + R1 n;1 

The price of any security at time tm satises

n
P
Sm = E f
P 0 Bmi Di + Bmn Sn Xm g
i=m+1
(1  m  n  N)

E f Xm g = conditional probability, given info. up to
P 0

time tm . In particular, if a security pays no dividends, then

B0m Sm = EP0 f B0n Sn Xm g

Prices of securities that do not pay dividends,

de
ated by the cost of money, are martingales under P0

B0m Sm = price de
ated by return on money-market account